Lessons from the Canadian Public Pension Fund Model

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What is the highly acclaimed Canadian public pension fund model, and can its methods be translated to other countries?

To address these questions, a panel of experts convened at the 69th CFA Institute Annual Conference in Montréal for an illuminating discussion. The participants were Ron Mock, president and CEO of the Ontario Teachers’ Pension Plan (Teachers’), which has C$171 billion in assets under management (AUM); Michael Sabia, president and CEO of Caisse de dépôt et placement du Québec, which has C$248 in AUM; Dana M. Muir, professor of business law at the University of Michigan’s Ross School of Business; and moderator Miville Tremblay, CFA, of the Bank of Canada.

So, what are the key characteristics of the Canadian model?

“I would say size, whilst important, doesn’t lead to an obvious advantage,” Mock explained. “What’s more important is clarity of purpose, what to focus on — paying pensions for generations to come — and governance.” To that end, Teachers’ set out to manage both the asset and liability sides of its plan’s balance sheet. The management of portfolio construction and security selection are the main points of emphasis on the asset side. On the liability side, the focus is the interest rate sensitivity of liabilities, aging demographics, and inflation protection.

At Caisse, Sabia highlighted the flexibility of the plan’s internal model of asset management. In common with other Canadian plans, 90% of assets are managed internally. At Caisse, this costs only C$0.38 per C$100 of assets per year. Internal management helps facilitate flexible and unique investment strategies. Caisse differentiates itself from other asset owners by acting as a business owner, developing partnerships, embodying patient capital, and investing in assets rooted in the real economy.

Canadian pension plan governance seems to facilitate investment flexibility. “Teachers’ has an independent professional board. That means we are independent of union politics,” Mock said. “Having that independence and running it like a business allows us to hire the right staff and build the right partnerships. Therein lies the secret sauce.” This approach enables Canadian pension plans to invest more directly than most other pension plans around the world.

Applying the Canadian Model Elsewhere

Wherever there is considerable union or political interference and no independent professional board — common circumstances in the United States and the United Kingdom — the Canadian approach would be impractical. The Canadian framework also means pension funds can invest in their own regions, which in other contexts would tend to invite political interventions. Sabia spoke passionately about how knowing more about the local economy than other investors gives Caisse a competitive advantage when making local investments.

Muir applauded the double-digit returns Teachers’ has earned in the last decade but expressed skepticism that the model could be easily imported to the United States. “Two points make it difficult for us [in the United States]: We have fewer than 20 public plans that have more than US$60 billion, so we need to work on scale if we are to import this model,” she said.

Secondly, on governance, “this model, in a US context, might ask more of a pension board than the US can deliver,” she said, pointing to what she sees as the greater social cohesion in Canada compared with the United States. “I fear that we are more prone to political meddling.” Paying market rates of compensation for staff, direct infrastructure, investment in local economies, and even asset allocation could be problematic for US imitators of the Canadian model.

Send Central Bankers to the Slammer?

One topic of contention was the influence of monetary policy. Tremblay read out the prevailing charge sheet against central bankers, accusing them of “killing all the returns from fixed income, making all other assets way too expensive, and keeping rates lower for longer and perhaps forever.” All this has certainly been a game changer for investors. But Sabia is unconvinced that central bankers warrant such condemnation. Unconventional monetary policy helped prevented an economic catastrophe, he said, and even though it has impacted the risk-free rate and caused investors to move into riskier assets, it has decisively driven innovation.

Over the last 30 years, fixed-income returns helped pension plans achieve returns in line with managing liabilities. “All that is over,” Sabia said. The future will involve less traditional fixed income, such as mid-market lending, sovereigns, and emerging market debt. Additionally, Caisse is looking at cash productive assets, such as leases, royalties, cell towers, and water systems. Faced with the impact of monetary policy, Caisse’s leadership is thinking differently about the future and considering investments in highly regulated infrastructure.

Mock explained that where Teachers’ uses derivatives, it is careful to mark to market on its balance sheet. Teachers’ has a potentially challenging mortality profile, with a membership that is educated, nonsmoking, 70% female, and long living — with over 130 centenarians. Marking these variables to market on its books has driven innovation in infrastructure and real estate.

Talent Development Fuels Innovation

Internal talent is another driver of the Canadian model, according to panelists. “Where normal market rates of return are going to be low for a long time in my view, what we have to lean on is the internal talent that has the capacity to add value,” Mock said. Teachers’ has created a global network of offices to facilitate this. This diversity is especially essential for the 28% of assets that these two large funds deploy in private equity, infrastructure, and real estate. Specialized teams are key. In its small hedge fund exposures, which are structured to maximize correlation benefits, Caisse has a full-time internal team vetting funds intensively, and it also uses hedge funds as a learning window on the latest innovations and techniques.

Caisse’s leadership tries to be creative in its investment entry points by buying distressed assets and considering greenfield developments. It also deploys innovative deal structures, intervenes in underlying investments to boost returns, and utilizes global partnerships. For example, Caisse recently acquired a large stake in Eurostar, the rail service linking London to Europe, and the transaction was facilitated by existing French partnerships.

“Operational excellence in the assets we are involved in is the enduring source of value creation, not financial engineering,” Sabia said. So, use of leverage is very limited, as is use of derivatives: 95% of derivatives use is focused on defensive currency and rates management. At Teachers’, risk and leverage are two different things, and leverage is used to control the portfolio and shift exposures around. “We are not shy about deploying derivatives,” Mock explained. But it is more circumspect about gearing exposures speculatively, and risk is not regarded as a VaR (value at risk) calculation. “Sector specialization is critical in risk management,” he said.

The panel concluded with the consensus that longer-term thinking is critical to success. The recent disaster at Valeant “is the poster child of what can happen when the focus of capital markets is on the short term,” according to Sabia.

Teachers’ likewise embraces the long-term view in constructing its compensation systems. As Mock said, “We avoid trying to dance around the noise that occurs from one quarter to the next.”

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo courtesy of W. Scott Mitchell

Video

Key Takeaways

The key drivers of the Canadian pension model are clarity of purpose and an internal model of asset management with innovative internal talent and flexibility of governance.

Wherever there is considerable union or political interference and no independent professional board — common circumstances in the United States and the United Kingdom — the Canadian approach to pension management would be impractical.

Over the last 30 years, fixed-income returns helped pension plans achieve returns in line with managing liabilities, but the future will likely involve less traditional fixed-income instruments, such as mid-market lending, sovereigns, and emerging market debt.

Transcript

Best Practices in Fund Management: Lessons from the Canadian Public Pension Model

Join panelists Dana M. Muir, Michael Sabia, Ron Mock, and moderator Miville Tremblay, CFA, as they discuss the fund model: investments, structure, and operations. The panel debates whether the Canadian pension model can be and should be replicated in other countries. The panelists also explain the blessings and curses of investing in less liquid assets.

Miville Tremblay, CFA: Let’s begin by describing further the key characteristics of the model. Ron, why don’t you start by telling us how size allows you to better diversify and what can you do that a smaller pension fund cannot do?

Ron Mock: I would say that size is something that, while important, is not — doesn’t necessarily lead to an obvious advantage. What we’re doing today, we were doing when we had $40 billion, $100 billion, $150 billion. And so size is — while it’s important, it’s not everything.

I think what’s more important — two things are really, really important. First of all, clarity of purpose, what you focus on. And secondly, governance. Governance we’ll talk about a little bit later, but for us, clarity of focus.

That focus is very simply, we have to pay pensions for generations to come. In order to do that, that means that we have to manage the asset side of the balance sheet and we have to manage the liability side of the balance sheet. The liability side really is about the interest rate sensitivity of our liabilities, it’s about aging demographics, and it’s also about inflation because we promise our members inflation protection.

And on the asset side, what we really focus in on that’s critically important is how we — but what we’re really good at is portfolio construction and security selection. We’re not very good at telling you where the S&P 500 will be six months from now. And so we manage the asset side carefully, we manage the liability side carefully, and from that perspective, it’s the difference between the two that we really focus in on because the goal is to pay pensions for generations to come.

Miville Tremblay, CFA: Thanks. Michael, is internal management still cheaper given the need to offer compensation that will be competitive to your staff? How do you balance cost on one hand and a capacity to attract and retain talent on the other?

Michael Sabia: Yeah. We think that the model of internal management of our assets — and we manage about 90% of our assets internally — and on that I think we’re consistent with the majority of our comparables among Canadian pension funds. Just to give you a couple of numbers. If you take all of the employees of Caisse de dépôt et placement du Québec (la Caisse) — we’re about 900 people — and then if you add to that a real estate operating subsidiary that we have that has about 1,500 or 1,600 people working in it — and they actually build, operate, run shopping centers, office towers, etc. — and you put all that together with the bit of external fees that we pay, our costs are somewhere around $0.38 per $100 of assets managed. And based on what we’ve seen around the world and among our Canadian counterparts, we’re pretty much — we are very much in the zone of our Canadian counterparts. And I think those numbers stack up very well against the costs of other funds outside of Canada.

So the model is competitive. I think very competitive from a cost point of view. To put it mildly. But that being said, Miville, in some ways, I’m going to echo what Ron said. I’m not sure that cost is really the issue. I mean, yes, it’s competitive and yes, we’re pretty low cost. But I think what really matters about the Canadian model and about internal management of assets is what it allows you to do. Because cost is one thing, but performance is what counts. And if you’re internally managing your assets, you have much greater flexibility to design your unique investment strategy, to make your decisions, and to use the expertise of your people to build an investment strategy and to put it in place.

At la Caisse, for instance, we’re building competitive advantage around a few principles of acting like a business owner, being a source of patient capital, investing in assets rooted in the real economy, developing quality partnerships, a variety of other things. That’s what we’re doing. And in these kinds of markets, the capacity to design your own investment strategy is, in my mind, the real payoff of the Canadian model, or with a heavy emphasis on internal management of assets. And I think that dominates the cost issue.

Miville Tremblay, CFA: Yesterday in the Research Foundation workshop, Keith Ambachtsheer talked about the importance of governance for the success of pension investment. Ron, what sort of governance do you have at Ontario Teachers’ Pension Plan (Teachers’)?

Ron Mock: I’m going to pick up on Michael’s points because he hit a number of them that are critically important. There’s two things in our governance model — and I think this governance model dominates the big eight, which basically is independence and run it like a business. Let me hit the independence part for a second.

Teachers’ has an independent professional board. That means that we are independent of union politics; we are independent of government politics; we are an independent private company. And we were established with the very clear purpose of paying generations — or paying pensions for generations to come. And so that independence allows us to do all the things that Michael just identified. And he went to the nub of the Canadian model.

Having that independence and also running it like a business allows you to hire the right staff, build the right partnerships. And therein lies the secret sauce, in my view, around adding value to the investments that we make. Which is why we are able to go more direct than most other pension plans around the world. And the Canadian model, with the big eight, is really all of them operate in this very similar manner.

And this point about independence is not an insignificant one. If we had a lot of political interference, a lot of union interference, and we didn’t have an independent professional board staffed by mostly CEOs of banks and insurance companies and central banks and other things, I’m sure that we would end up with a different result than we have today.

Miville Tremblay, CFA: Michael, you have many clients, each with their own liabilities. And, moreover, Caisse’s mission is to achieve optimal returns while contributing to Quebec’s economic development. Governance looks more complicated. How does it work?

Michael Sabia: Well, I think you picked the right verb. It looks more complicated. I’m not sure, at the end of the day, it really is. Yes, we manage assets on behalf of 34 different organizations, and that sounds like it could be complicated. In a way, we’re a bit like a mutual fund. We have 13 — but there are about 10 that are really important — portfolios. And our clients use those portfolios to make decisions about their own asset allocation and then we manage within that context or those parameters.

Now that being said, I think there are two really important things that make this actually pretty simple. Which is, first, we spend a lot of time and we work very hard to act as the trusted adviser of our clients. So their asset allocation decisions and how they combine the 10 major portfolios that we have is something that reflects a shared view between us and them. They all have different liability structures and so therefore, there are some natural differences. So that’s one thing.

The second thing is we as asset managers have a fair bit of flexibility around their asset allocation. The weighted average of the choices that they make, that constitutes our reference portfolio. But we have a lot of flexibility around that. So much so, for instance, over the last four or five years, I think we’ve surpassed the performance of that reference portfolio by about $8 billion. So we do have flexibility. So that flexibility, plus our role as a trusted adviser, makes the thing work actually in a pretty straightforward.

Now you mentioned contributing to the economic development of Quebec, and I just want to pick up Ron’s point about independence because I entirely agree with that. It could not be more important. In our case, we invest here in Quebec or, indeed, in Canada. And when we invest here, we’re investing because we believe we have a competitive advantage here.

The essence, in my mind, of the investment business is information and understanding of the context or the terrain in which you’re operating. Well, obviously, we know in great detail what’s happening here and, more broadly, what’s happening in Canada. And that gives us a competitive advantage. So as we say here, economic development and returns, they de vont de pair. They go together. And that’s our principle.

So, again, we do that on an independent basis. We do that as investors seeking returns. As we seek those returns, yes, we’re investing in Quebec businesses, we’re building those businesses. And, yes, we’re enhancing the economic development prospects of Quebec. But it’s in the context of an investment.

Miville Tremblay, CFA: Now, after hearing those gentlemen, what’s your first reaction about the Canadian model and how does it different from the DB funds that you know in the US and elsewhere?

Dana M. Muir: Well, my first reaction is, wow. These gentlemen are rock stars. What public plan in the United States would not be delighted to have double — have averaged double digit returns over the last 26 years as Teachers’ has? So that’s my first reaction.

But as an academic, as a lawyer, as someone from the US, I’d like to think about whether we could import this model to the US. And I think that they’ve touched on two points that make it difficult for us. We have fewer than 20 public plans that have at least $60 billion. So in a world of 4,000 public retirement plans and $5 trillion, we need to work on scale if we are going to import this model.

And second, there’s the governance issue. Both Michael and Ron have talked about the importance of independence. And I think this model, in the US context, might ask more of a pension board then a US board can deliver.

Miville started us out today by talking about the fact that Canadians are modest. Well, if we’re from the US, we need to be modest these days about our political system. And I’m going to posit that there’s a bit more social cohesion here in Canada; they may not have the long election cycles that we have, and I fear we’re more prone to political meddling. If that happens with respect to the need to pay market compensation, with respect to infrastructure and investment in one’s own local economy, even general asset allocation, that’s going to cut right at the heart of the Canadian model. And we would have to work on that, I think, in the US, in order to accomplish that.

Miville Tremblay, CFA: We’ll most likely come back to this big question. Now let’s turn to investment because we’re investment professional after all. Evil, evil central bankers have made your life miserable, killing all the returns from fixed income and making every other assets way too expensive. Low for long and perhaps low forever has been a game changer. How are you coping, Michael? How is your asset allocation changing as a result?

Michael Sabia: Well, first off, I don’t — I think central banks are not as bad as you paint them — as you make them out to be. In fact, I think I’d probably say that 2008 and 2009, and since then, central banks and monetary policy in general have contributed enormously to avoiding really an economic catastrophe that could have occurred in 2008 and 2009. So I’m actually on board with, by and large, with what monetary authorities have done on a global basis.

Now, that being said, though — so I think that’s an absolutely essential positive that was done given the severity of the financial and economic circumstance. That being said, you’re absolutely right. That with rates where they are and unconventional monetary policy that’s been put in place, that’s raised some issues. And it raises issues across all asset classes because of its impact on the risk-free rate, because of its impact on causing investors to move into riskier assets, which has influenced and impacted the price of those assets. So it’s something that cuts across the board.

But I’d like to focus in particular on the impact on fixed income, where I think, for all pension funds — and by and large for most investors — I think those impacts are really, really, really important. We all lived in a kind of Goldilocks world with respect to fixed income over the last 30 years where an asset class paid a pretty reasonable return. I mean, it varies, but over the last 30 years, between 5%, 6%, maybe in some places even 7%. So you were earning reasonable returns in an asset class that protected capital and that was well aligned with the liabilities — on the liability side of the ledger.

Well, that’s over. That is over. Point finale. And that raises a bunch of issues about, what is the future of fixed income and how to think about it for a pension fund. So on our side, we’re focused on a few things. One, we’re starting to do a lot less traditional fixed income in the sense of government bonds or highly rated corporate credit. Number one. A lot less traditional stuff.

Two, we’re starting to try to do fixed income differently by looking at different types of assets that have, in our minds, a better risk–return profile. So things like mid-market lending where there are significant opportunities, particularly in the US market, because banks have pulled back largely because of regulatory intervention. Or we’re beginning to look at investing in sovereigns in emerging markets.

Or third, we’re also beginning to look at other kinds of assets that will pay a pretty steady stream of income at a pretty low risk associated with it and that protects value — protects the value of the capital over the long term. Different kinds of — very specific different kinds of asset leasing or streams of income from royalty systems. Or even things like cell towers and water systems.

And those two bring me to the third thing that we’re trying to do, which is just doing different things. And what do I mean by that? Well, we think about core infrastructure, we think about core real estate. When I use the word “core,” I’m talking about relatively low return. Something in the 5%, 6%, 7% zone but with very, very high dependability on those cash flows. Say, a highly regulated infrastructure with guaranteed availability payments from the government.

My point being that faced with the impact of monetary policy, faced with, I think, at least for the next 10 to 15 years, different macroeconomic circumstances than we’ve all grown up with over the last 30 years, there’s a need to think differently about the future of fixed income. And the traditional thinking is not going to deliver what needs to be delivered in a world that’s changed fundamentally.

Miville Tremblay, CFA: Thanks. Ron, for Teachers’, a low discount rate means ballooning liabilities. How do you protect yourself? How did you protect yourself, and where do you get the returns to pay the pensions?

Ron Mock: So, as I mentioned earlier, we look at both sides of the balance sheet, the assets and the liabilities. And we have always taken the liability side — an interest rate exposure on our liability side — as our biggest exposure. And our discount rate on the liability side is something that we’ve been marking to market since the beginning. We look at where real rates are, and as real rates have fallen, we mark our liabilities to market effectively off of that. We don’t hold a false discount rate inside the liability side.

Additionally, as mortality has changed, we have changed along with it. So, for example, in the 1970s when teachers were — the average mortality was about 72 years of age; today it’s actually 92 years of age. Seventy-five percent of our teachers are female; they stopped smoking a long, long, long time ago, and we have about 130 teachers who are over the age of 100. So we actually had to start thinking —

Michael Sabia: I don’t think teachers are working hard enough, Ron.

Ron Mock: That’s exactly right.

[LAUGHTER]

Dana Muir: Oh, wait.

Ron Mock: That’s exactly right.

Dana Muir: Wait.

Michael Sabia: Wow.

Ron Mock: There are actually teachers who are receiving a pension who have been receiving it longer than I have been living. So this mortality issue is not an insignificant one. And we’ve actually marked ourselves to market against that.

What has that done? It’s driven innovation. We’ve had to innovate around putting infrastructure in place. We’ve had to innovate around real estate. And I’m going to come back to Michael’s point earlier which is, in this low rate environment, where are we going to get our returns from? We’re going to get our returns from the talent that we have in our organizations.

We have about 100 people that are focused on nothing but private equity globally. We have an office in Hong Kong, we have offices in London. Operating on a global scale, you need the talent to pull it off. When you’re buying airports and high-speed trains and toll roads, which you’re going to own for the next 30 to 40 years, you have to have the in-house talent who not only can do due diligence and buy these assets, but they have to have the skill set to operate and grow EBITDA effectively over this length of time and deal with it.

And so where normal market rates of return are out there and available to everybody, and they’re going to be low for a long time in my view, what we really have to lean on is the internal talent who has the capacity to add value. And that was Michael’s point earlier. And I think that’s something that you will find common to the Canadian model across all the big eight.

Miville Tremblay, CFA: You’ve answered the next question about infrastructure. But, Michael, I would like to have your views because both of you have about 28% of your assets in the real estate, private equity, and infrastructure. And so what’s your recipe? Is it similar to Teachers’ in terms of those assets?

Michael Sabia: Yeah. Yeah. I think it is. I think we’re — most Canadian pension funds are doing the same kinds of things in private equity, in infrastructure, in real estate. Ron has a real estate subsidiary in the same way that we have that’s actually in the business of building and developing and operating shopping centers, buildings, and other things. So I think there’s consistency across in what we’re trying to do.

Just to pick up your point, maybe — one of the things that’s happened, as I was saying a minute ago about the impact of monetary policy, we have seen, on a global basis, the price of these assets has really stepped up over the last number of years. And that does — that is a challenging environment now and it does place an emphasis on being cautious, but more important than being cautious, being selective. And that asset selection seems to us to be just an absolute sine qua non in the kinds of markets that we’re facing. Being highly selective.

So for us we’re trying to do three or four things as we continue to invest in these less liquid assets that we believe, for all the reasons that Ron just talked about, are a very important part of the future in trying to close the returns gaps that we’re going to have because market returns are going to be lower and because fixed income, etc., as I was talking about a few minutes ago. So how do we do that? Well, try it as — as I say, trying to do three or four things.

One, we’re trying to be creative about our entry point into these assets. We’re trying — this sounds a bit predatory and I apologize for that — but we’re trying to benefit from financial distress that exists around the world and we’re trying to find creative ways of getting into an asset — very low-cost ways of getting into an asset — or we’re trying to benefit from complexity.

Miville Tremblay, CFA: Because there is an issue of prices being a bit sky high.

Michael Sabia: Yeah. No, there is. Prices are high. And the thing about a less liquid asset, when you buy it, as Ron said, it’s going to be with you for 10, 15, 20 years, so the price of entry really matters. Which is why, again, we’re trying to be creative about the pricing and the structure that we use to go in. Second, we’re being very focused on deal structures and trying to be innovative about how we structure things so that we protect our downsides. And we use operational improvement in the asset as a way of creating upside returns.

We’re very focused on working with partners — operating partners — that can sometimes get you access to assets. Avoiding auctions. We recently acquired a big chunk of Eurostar between — the high-speed train service between Great Britain and Paris and Brussels — and we were able to do that because of a very long-term relationship we’ve had with the French national railroad company. So that’s important.

And then finally, the last thing we’re trying to do is we’re trying to do innovative things. So for instance, in infrastructure, we’re more willing now to do greenfield than we used to be in the past. Most large institutional investors are focused on brownfield. Well, in this environment, in these markets, we think we need to extend a little further and be willing to do greenfield. So you have to differentiate yourself, you have to be a little bit more creative, a little bit more innovative to get into these assets at prices where you think you can continue to deliver interesting returns over the medium and longer term.

Ron Mock: I think one of the points — Michael, if I could just pick up on this — about looking for assets. One of the benefits of operating on a global platform, which we all do and we go direct and we all look for partners globally that are critically important to our success, is there’s always something going on somewhere in the world. And where South America may be way out of favor right now, over the next two to three years there’s already stuff that’s starting to move and look interesting. And while it takes a lot of risk management and a lot of strong partners in regions like that, it does create opportunities.

In the developed markets, in certain European and North American markets, because of the interest rate story, yes, things are expensive. But there’s always something happening somewhere that you can capitalize on. And that’s really the benefit of having this global platform.

Miville Tremblay, CFA: Dana, are any of those answers different from what you’ve seen in the US?

Dana Muir: Yes and no. The World Economic Forum team that I worked on looked at this question of the low rate environment for long-term investors. And we looked at a global scale and found that long-term investors are interested in these infrastructure projects. But pension funds overall have only been able to invest about half of their target amounts in infrastructure for the same reasons that Ron and Michael are talking about. So we see that same set of challenges.

And then the other thing is, and both of them at least inferred this, is that it’s a scale issue. They have operations worldwide and partners worldwide. But that takes scale.

Miville Tremblay, CFA: Ron, CalPERS and many other pension funds have pulled out of hedge funds because of high fees and disappointing returns. What’s the role of external and internal hedge funds in your organization?

Ron Mock: In a word, it’s correlation benefit. If there’s one thing on the asset side that we focus on, that is — not to get too technical here — but let’s get the best Sharpe ratio, let’s get the best risk-adjusted return that we can get for our asset portfolio. That same comment applies actually all the way through to our liabilities and our funding ratio. But let’s just take it on the asset side for the time being.

So getting that is critically important. And if — there’s a few free lunches out there — I guess there’s never really a free lunch — but one of them we look upon is correlation. And for us, hedge funds, which have had a difficult period, there’s no question about it, and it’s getting tougher and tougher to pick really, really good ones that can deliver this benefit. But it’s less about a return and more about a risk-adjusted return. And, in particular, in a space where there are correlation benefits.

This is why we’ll do different things. Different things like if we’re starting to look at everything from music royalties and other things, which are independent and our governance allows us to go into some of these unique things. They don’t go up and down with the equity market. They provide just steady cash flow.

It’s not an asset class for us. Be very clear. It really is intended to provide incremental cash and a correlation benefit. But that’s really why we do it. So we construct that portfolio very, very carefully in order to accomplish that end. So if we get LIBOR or T-Bills plus 250 to 450 bps out of that portfolio, we’re fine. We’re not looking for it to replace our equity or our private equity or any of our core asset classes. It is about portfolio construction.

Miville Tremblay, CFA: But there is some of that is done internally.

Ron Mock: We do the same thing internally for the same reason. And at the end of the day, if it can add value above and beyond our benchmark and deliver uncorrelated return stream, then — and each year that adds probably something like 30, 40 bps of return above benchmark — then we’re going to do that all day long, provided we can get the quality managers and we feel very comfortable with the risk. We don’t take a lot of risk in this particular area. We look for unique and differentiated return streams.

Miville Tremblay, CFA: What about the Caisse?

Michael Sabia: I would say pretty much the same. We have a very small exposure to hedge funds. About $4 billion out of — on a net asset basis, $250 billion. So it’s quite small. We do it for two reasons.

First, the uncorrelated returns that Ron mentions. Our CIO has an expression where he describes what we do. Hedge funds is a very small cherry on the top of the sundae. So that’s one reason.

The second reason, and in my mind, honestly, given how small our exposure is, really the most important one. We have relationships with 30 funds. So it’s pretty limited. And in each and every case, we’re looking for them to bring us something in addition to returns. So we invest in hedge funds to give us a window. To give us a window on industry, emerging practices, new ideas, innovation.

And that’s a very important — because learning in a world that’s changing as much as ours is changing, learning is so important in keeping your eye on what are the latest ideas that people are working on. Really, really core in our thinking about how we build and continue to update our investment strategy. So hedge funds play a role in that because it gives us a window. We’re looking for insights on better ways of doing research, insight into industry best practices. That’s what we expect.

I would say, just picking up Ron’s point, we have a team that does this pretty much full time. We vet those funds intensively because we’re very focused on issues of transparency, understanding their risk profile, etc. So it’s a very intensive process where we work very hard with these firms before we make even small financial commitments. But as I say, our view on this is, it’s about learning, it’s about a window.

Miville Tremblay, CFA: OK. I’m going to use now a four-letter word for most pension funds. Leverage. OK. More than four letters, but you get the picture. Both Caisse and Teachers’ use some average through borrowing and derivatives. What’s your policy regarding leverage? Michael, why don’t you start?

Michael Sabia: Look, we’re a fundamentals-oriented investor. We invest in assets that are rooted in the real economy, be that toothpaste from Colgate Palmolive to bridges to ports to airports to buildings. Those are the assets that interest us. We’re, as I say, focused on the real economy.

We believe and we have a deeply held conviction that operational excellence in the assets that you own is the enduring source of value creation, not financial engineering. So as a corollary of that, our use of leverage is actually quite limited. I think were about 12% or 13% — 14% of our gross assets. And essentially — I’m simplifying a little bit — but essentially all of that is used in our real estate division in a manner consistent with the financing of real estate on a global basis.

So our use of leverage is actually very, very limited. It used to be different but we’ve changed it now. And it’s a very, very limited thing. Similarly, Miville, on derivatives, again, consistent with what I said about the kind of investor we are, pretty limited use. And when we do use derivatives, it’s essentially always in a defensive context. Defensive, by that I mean, about 95% of our use of derivatives is focused on either currency management or rates management.

Again, always with a defensive mindset. We don’t think about the use of derivatives as an independent source of profit. I think something less than 8% of our total risk is associated with derivatives. So we’re — we may be a bit of an outlier, but we don’t use leverage very much and our derivatives focus is very much defensive.

Miville Tremblay, CFA: Teachers’ is somewhat different.

Ron Mock: First of all, not to sort of unravel it, but for us, risk and leverage are two different things. And this leverage conversation can get pretty complicated pretty quickly. If you looked at LIBOR or a futures contract on LIBOR for a million dollars, it’s going to be very low risk but lots of high leverage. If you leverage an S&P future, not very much could get you lots of volatility.

We use leverage to control the portfolio, to shift the portfolio and exposures and risk factors around, and we can be long as much as we’re short in here. I think, at the end of the day, when we think of how we’re going to employ leverage, it also comes into play in terms of our cost of capital. We have a balance sheet with assets and liabilities and when we raise capital for funding, we want the lowest cost of capital that we can get our hands on. Oftentimes, if we want equity exposure, we’ll get that equity exposure through equity swaps where it might be cheaper than actually the cash alternatives.

So we’re not shy about employing derivatives. We’re not shy about — the way some people would argue — it’s leverage. It’s never really outright leverage, though, where you actually go out and get long equities and lever them up two to one. We don’t think that way. Employing derivatives is really about balancing out the portfolio, getting exposure to the risk factors that we need, and eliminating the risk factors that we don’t want to have in the portfolio as part of portfolio construction.

Miville Tremblay, CFA: We’ve talked about all sorts of ways to achieve returns but you also have to manage risks. Another question for all of you. What do you see as the most important thing for successful risk management? And maybe, Dana, you could start this time.

Dana Muir: I think you have to think about risk depending on the region and where you’re investing. It’s different to buy a bridge in the United States than to buy the Brussels airport. And —

Michael Sabia: Easy to say that now.

Dana Muir: It is — yes. Just a terrible situation. But I was in Hong Kong last week and part of the conversation was about the changing labor environment in China. The next generation of migrants is very different than their parents, and they are finding ways to organize, use social media. And that will change investors’ perceptions in China. And in order to understand those risks, I think you have to have people and offices on the ground in those areas where you invest. And these folks do.

Miville Tremblay, CFA: Ron?

Ron Mock: First of all, for us, risk and risk management isn’t just of VAR calculation. Risk management is a culture. That’s the first point. Risk-conscious culture is something that we drive into our organization each and every day.

The second thing I’d highlight is, once again, where risk is often thought of as a VAR calculation, I would argue that right at the coalface, specialization — sector specialization — is absolutely critical to risk management. I’ll give you a case in point. If we were going to buy the Mexico City airport, I want to know that we could send a team of 10 or 15 people down to do the due diligence who do nothing but airports. We don’t want to send a due diligence team that last week bought a bank, two weeks before that they bought a Arby’s restaurant chain, and now they’re going to Mexico to look at an airport.

Sector specialization, whether it’s toll roads, airports, or anything along these lines, becomes critically important. Because these people are deeply specialized. When you own a high-speed train, as Michael just identified, for 30 years, 40 years as a concession, you have to have the people that understand how to operate those assets. So it’s a culture. It’s a sector specialization.

This deep robust expertise becomes very, very important in all of that. And then, of course, ultimately, at the end of the day, you have to have the systems in place, both for liquid assets and, frankly, for private assets that are capable of managing and monitoring the risk of the portfolio.

Miville Tremblay, CFA: CFA Institute has spoken many times against the bane of short-termism in the financial markets. And both of you gentlemen have a strong view on the topic. I offer you the opportunity to vent your frustration in front of a friendly crowd. Go ahead and enjoy.

[LAUGHTER]

Michael, maybe first?

Michael Sabia: Well, we’re a long-term investor. And we try to focus on that. To pick up a word that Ron used a minute ago in the context to risk, but a word that is so important in my mind in the investment business: culture. And we try very hard all the time in working with our folks to just inculcate and build this structure — this culture, excuse me. It’s about the long-term that matters.

We talk internally all the time about how we’re builders. Yes, we’re investors. But we talk about being builders. Builders of great companies, builders of great buildings, builders of great infrastructure projects or other things. We’re builders.

We operate with a business owner mindset. We want to understand assets deeply, we want to own them for a long time, we want to make them work better. Because we think that, as I said earlier, is the source of enduring value creation. So we’re very focused on building in the long term.

Now, in counterpoint, short-termism. There’s actually a very short way of describing that these days. Valiant. Now, Valiant from the beginning was an accident waiting to happen. Valiant expresses everything that’s wrong with short-term thinking in equity markets. Because Valiant was a business built to satisfy the short-term impulses of equity managers in the public markets.

The whole business strategy, the Pac-Man game that they played, in my own judgment and I’m proud to say that we were never a big investor — we bought a small, reasonable small amount of stock and sold it at the right time, thank God, so we were never much in the stock. But Valiant, given what it did — how it just consumed — consumed in the sense of shutting down research and development, overpricing products, just maximizing short-run returns in order to drive up the stock price — I mean, it is the poster child of what can happen when the focus of capital markets is on the short term. And not just in terms of the value destroyed by Valiant, but the impact that it had on people, the impact that it had on people’s perception of how the capital markets work, and of how compensation works and the whole issue about the growing distrust that people have in the market system that we all live in.

Now, Valiant may be an extreme example, but I think it’s a poignant example of why capital markets and the people who work in them have got to focus more and more and more on building over the long-term and a lot less on just maximizing short-term returns. Because Valiant tells you that it just doesn’t work.

Miville Tremblay, CFA: Ron, can you up that?

[LAUGHTER]

Ron Mock: I’m just going to build quickly on Michael’s point. I said it earlier, I think when it comes to adding value, I know our capabilities and what we’re good at and what we’re not good at. What we’re good at is portfolio construction for the long haul. We can work on that. We’re really good at security selection, whether the security is an airport or a private company or a publicly traded stock. I feel comfortable with that. We can add value.

We can’t tell you where the noise of the S&P or anything else is going to be three to six months from now. It makes no sense for us to focus in on short-term return profiles like that. I think, frankly, the media and a lot of other aspects that play in our world and our markets certainly reinforce short-termism. But as a long-term investor, it makes much more sense to us to figure out how we can add value over the long haul.

We reinforce that with compensation systems which are long-term in nature and not short-term. And so everything that we do reinforces having a long-term view — a reasonably long-term view and avoiding in and out and trying to dance around the noise that occurs from one quarter to the next. It doesn’t make sense.

Miville Tremblay, CFA: I’ve received many great questions and I apologize in advance because it’s impossible, unless we stay here until midnight, to go through all of them. But there is one, and gentlemen you’ll excuse me, but it’s not mine, it’s somebody’s question, and it’s for Dana. Would a US pension fund be ready to pay $2 million per for a CEO for a year?

Dana Muir: I’m sorry. One more time.

Miville Tremblay, CFA: Would the US accept to pay a pension fund CEO $2 million a year?

Dana Muir: No. Just think about the current political environment in the US. I think that regardless of which party we’re talking about, we are in the midst of the biggest populist movement that our country has probably ever seen. And even if you could promise me 200 bps, I think it would be the brave politician or pension board that would pay the CEO $2 million or more a year.

Miville Tremblay, CFA: A question that came on — there are many guises and I wish I could void myself but it comes too often — do negative interest rates have an impact on your investment decisions? Just for the record, the Bank of Canada has negative rates in its toolbox, but we don’t wish, we don’t hope, and we don’t expect to use it. But it’s being done elsewhere. So when you invest abroad, how do you deal with that? Yes, Michael?

Michael Sabia: Well, I hope you leave negative interest rates in your toolbox and I hope you keep it locked. And then you throw it overboard somewhere and it sinks to the bottom. Because I think negative interest rates are a really bad idea.

And I don’t think they’re going to work and I think they are a manifestation of a broader phenomenon that we see in the world today, which is monetary policy — it’s always important — but monetary policy is running out of gas. And it’s running out of gas because it played a critical role in getting us out of the financial crisis, it’s a critical role in supporting tepid levels of economic growth that we’ve been able to achieve since the financial crisis. But monetary policy in general — I mean, politicians have relied on monetary policy to propel the OECD economies. And for that market — for that matter, the emerging markets as well.

But what we’re — the law of diminishing marginal returns is setting in and negative interest rates are just a manifestation of how much those diminishing marginal returns have already set in. So overall, generally, I think they’re a bad idea and I don’t think they’re going to work for a whole bunch of reasons which we don’t have time to talk about today.

Now, as to whether or not it immediately influences investment decision making on our part, the answer to that as a long-term investor, by and large, is no — (a) because we think that they’re temporary phenomenon, and (b), with interest rates globally as low as they are, the big picture of what you have to do to try to generate returns — which we talked about earlier this morning — they don’t fundamentally change it.

The one area, obviously, where we think they do have some impact but we’re not a particularly big investor in this sector, but it does have some impact on the banking sector. But again, globally we’re not a big investor in banks and therefore it hasn’t affected us a whole lot.

Miville Tremblay, CFA: Maybe a question for Ron on ESG. What’s your policy? Do you integrate those factors in your investment process — the environment, the social, the governance?

Ron Mock: We’re very actively involved in the world of ESG. We’ve signed the UN protocol. We did this about five, six years ago. We started integrating it into our investment program five, six years ago. And it really is now inculcated as part and parcel of everything that we do.

We basically start with the view that we look at everything through a risk lens. For those people that are focused in on ESG issues, when we’re buying an asset we try and understand what the implications are through time about stranded assets and how an asset will perform. So it’s through the lens of risk that we start. That becomes pretty important.

As a fiduciary, we have to deliver on the pension promise. We do not have screens, but we also know that if we’re investing things — for example, coal and other assets — that we could find ourselves left holding the bag a number of years out, which doesn’t help our return profile. So through the lens of risk, that’s critically important.

Another part of our program is about engagement. Those companies where we have sizable investments, we spend a lot of time engaging with the CEOs and the senior management to try to understand what their programs are going to be around environmental, social, and governance issues. And we focus a lot on environmental. We also focus on the social aspect. And this becomes key because when you’re investing globally as we are, it’s not — you’ve all heard about what happened to Google in Europe in the last month and a half or so. You’ve probably all heard about what happened to Starbucks. And so license to operate and social sense is also important.

And I will tell you, when you’re involved in direct investing, it’s one of the things that you can’t get away from. If you’re investing in a private equity fund, you can sort of quietly sit behind the private equity fund as they’re out in front. But when you’re actually direct investing with these companies, if they start to do something that’s inappropriate, then it reflects on your reputation. So social issues become very key.

Governance: Teachers’ and all the Canadian pension plans have been really, really high on governance. I’ll just leave it at the point that governance is good business. And we reiterate that and support it 1,000%. So across the E and the S and the G, environmental critically important, social — social license to operate, critically important, governance is just good business.

Dana Muir: Can I follow up on that very quickly?

Miville Tremblay, CFA: Yeah.

Dana Muir: And that’s just to say that in the US, I think that the Department of Labor’s guidance in the fall for ERISA plans is probably best practice for public plans as well. And it’s exactly what Ron is talking about. The way I read that guidance is that you focus on ESG in terms of risk and you’re safe.

Miville Tremblay, CFA: We’ve got four minutes left, so one minute each for my closing question that we alluded a bit. To what extent should the Canadian model be actually followed by others or inspire other pension funds? Michael, why don’t you start?

Michael Sabia: Well, the disclaimer at the outset is the obvious one, which is, I’m biased. That being said, again, I think the big challenge in the investment world today, given everything that’s changed — and I think anyone who underestimates the inflection point we’re at between the last 30 years — and we’ve all grown up in that world — and the next 20, the next 20 are going to look a lot different than the last 30. And that means you’ve got to think differently. You’ve got to think more creatively.

Standard operating procedures are your enemy. And by and large, everything you learned in school, mistake. Move on to other stuff. So that sort of — come back to the Canadian model — given that we’re at an inflection point, given that strategies have to change, I want to be able to manage our assets internally because that increases our degrees of freedom to do the things that we think are going to be required to do to capture and to manage in this very difficult post-inflection point world that we’re going to be going into. So I think that internal control of your assets, hiring quality people, hiring top-quality investment professionals, distributing them around the world, being able to go where the best deals are, doing a direct investment as we all do, I think that’s a model that is advantaged given the magnitude of the change that we’re in.

Miville Tremblay, CFA: Now you’re stealing time to Dana.

Dana Muir: OK. Absolutely inspirational. But from a US perspective and other places in the world, we face these issues that I talked about. One is we need to work on scale. And working on scale would be good for us whether or not we follow this model. And second, we need to focus on the long term. We can really learn something about this focus on paying pensions.

Miville Tremblay, CFA: Ron, the last word.

Ron Mock: I think when it comes to the Canadian model, I think we have to remember that what we’re doing now, which is a little bit different for pension plans, has been built up over the last 20 years. The expertise has been built up over the last 20 years because of that independence that I spoke about earlier. And it’s allowed us to build internal expertise that’s critically important.

I don’t think it makes sense to go rushing into all sorts of alternatives classes — alternative classes — infrastructure, real estate, and private equity and other things — directly if you do not have the internal capacity to manage it. By all means, carry on through funds, carry on through the various funds that are out there and get exposure if you think that’s appropriate. But I would argue, know what you’re really good at and know where you have to come up the learning curve a little bit. So before you jump in with both feet because other people are actually doing it, make sure that you’ve got the appropriate expertise to pull it off.

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Mark Harrison, CFA, is director of journal publications at CFA Institute, where he supports a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

More than 130 business leaders have responded to a deadlock in the UK Parliament by signing a letter calling for a second Brexit referendum to prevent a chaotic withdrawal from the EU. "The only feasible way to do this is by asking the people whether they still want to leave the EU," the letter says. CNBC (17 Jan.)

The Chinese government is likely to establish a growth target for this year that falls short of the 6.5% target set for 2018, sources said. This year's target is expected to be 6% to 6.5%. China Daily (Beijing) (18 Jan.)

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